Overcollateralization

Overcollateralization is the practice of posting collateral worth more than the amount borrowed. It is common in on-chain lending, where a borrower locks up one crypto asset to take out a loan in another. The value of the collateral is set higher than the loan so lenders keep a cushion of protection.

That cushion is the buffer between the collateral's value and what is owed. If the collateral falls in value, the buffer absorbs some of the drop before the loan is at risk. The larger the buffer, the more room a position has before it becomes undercollateralized.

If the collateral value falls too far, the loan can be liquidated. In a liquidation, part or all of the collateral is sold to repay what is owed, which protects the lender. Overcollateralization reduces this risk but does not remove it, since collateral prices can move quickly.